How to know when it’s time to leave the party

Commentary: The track record of the 200-day moving average

CHAPEL HILL, N.C. (MarketWatch) — How would you like to find an indicator that would reliably let you know when the bull market has finally come to an end?

I thought so.

And you’re not alone. Investors — tantalized as they are by the prospect of the stock market “melting up” as the trillions currently in bond funds get transferred into equities — don’t want to prematurely leave the party Wall Street has been throwing. Yet they also are worried about the downside risks of a bull market that is unquestionably getting rather long in the tooth.

My first stop in this search for an indicator that will tell us when to get out: The 200-day moving average, one of the most widely-followed market timing indicators. I’ll be focusing on others in coming days, and I encourage you to email me with suggestions of which you’d like to see me subject to historical scrutiny.

Investors who rely on the 200-day moving average consider a bull market to have ended, of course, whenever the major market indexes drop below their average level of the previous 200 trading sessions. Unfortunately, I found that this indicator leaves a lot to be desired.

Consider what I found upon backtesting the 200-day moving average back to the late 1800s, when the Dow Jones Industrial Average
DJIA, -1.11%
was created. Specifically, I constructed a portfolio that was fully invested in the Dow whenever it was above its 200-day moving average, and otherwise completely out of the market.

(I made a number of simplifying assumptions, by the way: I did not credit this hypothetical portfolio with the interest it would have earned when out of the market; nor with dividends when invested in stocks. By the same token, I did not debit the portfolio for transaction costs, which would have been considerable. I’m confident that these assumptions did not materially affect my conclusions.)

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At first blush, the results were impressive. Compared to a 5.1% annualized return for buying and holding over the last 116 years, the 200-day moving average portfolio earned a 6.7% annualized return. Better yet, this outperformance was produced while simultaneously reducing risk by a big amount.

Unfortunately, this moving average system has been a disappointment over the last several decades. When measured since the beginning of 1950, for example, this hypothetical moving-average portfolio made 6.4% annualized, compared to 7.0% annualized for buying and holding. And over the period just since 1990, it’s been even further behind — 3.8% annualized for buying and holding, versus 7.3% for buying and holding.

The picture that emerges is of an indicator whose best years came in the early part of the last century. Its market timing value has gotten progressively worse in recent decades.

What might be causing this diminution? One possibility is that the veritable golden-egg-laying goose was gradually killed by more and more investors paying attention to the 200-day moving average. Another that statisticians always insist that we take seriously is that its success in the early years was little more than a fluke.

In any case, the 200-day moving average’s recent track record is particularly sobering.

Consider the last two occasions when the Dow dropped below its 200-day moving average. The first came early last June, when it caught almost to the day the exact bottom of the May-June correction. Needless to say, that is just the opposite of how you would want a top-signalling indicator to behave.

The second time came immediately after the presidential election in November. And though the Dow did fall a couple of hundred points over the few trading sessions following that sell signal, within a week it quickly reversed course. By the time the 200-day-moving average flashed its subsequent buy signal, the Dow was higher than where it stood on the day of its sell signal.

The bottom line: If the 200-day moving average is the best we can do in our search for our top-identifying indicators, the rational thing to do would probably be to give up and resign ourselves to buying and holding. Let’s hope there’s something better.

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